Bank of Israel Governor Stanley Fischer yesterday announced an interest rate hike for September 2009, thus becoming the first central banker throughout the developed world to raise interest rates since the economic crisis began last year.

The increase isn't big: Fischer is raising the Bank of Israel's overnight lending rate to banks by 0.25%, to 0.75%.

A rate of 0.5%, which had been in place for five months, is all right for an economy in deep recession, a top official at the Bank of Israel told TheMarker yesterday. But Israel isn't in deep recession: Enough indicators show improvement to warrant the increase, he said.

"Interest of 0.75% is still low, even negative in real (inflation-adjusted) terms," he said. He also stressed that the rate hike doesn't necessarily portend more around the corner.

In its announcement, the central bank explained that inflation has been raising its head: The consumer price index increased by 1.1% in July, confounding forecasters. Since the year began, the CPI has increased by 3.2%. Over the last 12 months, it's risen by 3.5%.

Evidently it was time for the central bank to take inflation into consideration at the expense of economic growth. Lower interest rates can support growth, but also encourage inflation. The Bank of Israel's central mission is to keep inflation within the range of 1% to 3%, which is defined as price stability. Inflation of 3.5% over the last 12 months is above the target range.

The central bank acknowledges that inflation has been boosted to a large degree by nonrecurring elements - tax hikes, including VAT, and the higher price of water. But even minus these one-time elements, inflation has been hovering near the ceiling of the target range. Also, inflation expectations as implied in the capital market are at about the mid-point of the target range mainly because analysts are expecting rate hikes, the Bank of Israel explained.

Some analysts had anticipated that Fischer might raise the rates, but certainly not all. "The Bank of Israel's move was startling," says Ron Eichel, chief economist at the Meitav investments firm. "I think he'd have been better advised to use other monetary tools to start with, but it's a legitimate tool for the Bank of Israel, an attempt to strike a balance between growth and inflation," Eichel added.

Most central banks aren't expected to start raising their interest rates before year-end 2009 or even the middle of 2010. But Israel's economy is considered to be in better shape than most.

The retail banks will be raising their interest rates on overdrafts on Friday, also by 0.25%.

Outraged in business circles

Business elements howled in protest at Fischer's move, which had not been widely anticipated. Many thought the governor would wait another month or more before jacking up rates.

Uriel Lynn, president of the Israel Chambers of Commerce, said Fischer should have made his decision based on the greater good of the economy and public, not due to pressure. Israel is the first to raise its interest rates, Lynn said, which could trigger violent fluctuations in the movement of capital and massive purchases of shekels, which would strengthen the Israeli currency against the dollar. That would be terrible for exports, Lynn said. For that reason alone, the central bank shouldn't have raised its interest rates.

Manufacturers Association leader Ori Yehudai was no more complimentary.

"I regret the governor's decision to raise interest rates. His choice to move ahead of the global monetary markets is dangerous for Israel's economy, The greatest threat is that the rate hike will deliver a psychological message to the markets about a change in direction in monetary policy ... opening a positive interest rate gap with the U.S. could accelerate the appreciation of the shekel, which will impede the recovery of Israeli exports."

Leaping into the forex market

Immediately after announcing its interest rate hike for September, the Bank of Israel swooped onto the marketplace and bought about $50 million, possibly more. Market animals surmise that upon hearing the news, players dumped dollars onto the market, which the central bank hastened to soak up.

Ultimately the dollar ended the trading day roughly where it had began: 0.4% weaker against the shekel, at an official exchange rate of NIS 3.804.

The Bank of Israel had been busy in the market before the announcement as well, buying somewhere between $50 million to $100 million at about NIS 3.80 per dollar.

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